Option Basics

[wayneL]

Hi

I am getting some PMs about some of the basic concepts in options. I guess we option afficionados tend to to talk over the heads of beginners and this could make them reluctant to ask basic questions.

I don't mind answering PMs, but would rather answer them on the public forum so all beginners can benefit.

So this thread is for the absolute basics. Ask the most basic stuff here, and I, or the other option junkies here will answer.

To kick off:

What is an option? There are two types of course; a call and a put.

The buyer of a call option:

...has the right, but not the obligation to buy shares at a set price (the strike price), on or before a certain date(the expity date).

The seller of a call option:

...has the obligation, if called upon, to sell shares at a set price, on or before a certain date.

The buyer of a put option:

...has the right, but not the obligation to sell shares at a set price , on or before a certain date.

the seller of a put option:

...has the obligation, if put, to buy shares at a set price, on or before a certain date.

In Australia, the standard contract size is 1000 shares

In New Rome, the standard contract size is 100 shares.

these contract sizes may vary due to corporate action. Always double check the contract size before trading.

All questions welcome.

 

[NettAssets]

One thing I always get asked about is trading company options and people confusing them with call and put options or ETO's.

A company option is traded on the exchange like an ETO (exchange traded option) but it is traded as a normal share, not as an option. This means for a company option you will get a share script from the company's share registry - which you will not with an ETO.

A company option is priced in similar fashion to a call ETO except part of its price is not payable until exercise which you may do at any time up till expiry. With an ETO there is no exercise price so the price you pay up front is the total cost of buying the call.

A company option may still expire worthless if the share is trading at less than the exercise price.
Regards
John

edited for clarity on expiry

 

[hissho]

hi all(Wayne, Modragan and Margaret)

has anyone heard of the following(for US market only)?
optioninvestor
http://www.optioninvestor.com/newsl...id.aspx?aid=194
and
options hotline:
http://dailyreckoning.com/LP/SteveS...onsHotline.html

and the latter even claimed his father was a famous options guru for more than 40 years, by the name "Paul Sarnoff"...

My dad Paul Sarnoff was one of the legends in options trading for more than 40 years. Wall Street turned to my dad for the best in options trading advice. He is to options what Warren Buffett is to stocks - a genius! In fact, it was my dad who started Options Hotline, his private options advisory service available only to a select few, back in 1989.

About 30 years ago, my dad brought me into the "family business" - sort of a Sarnoff & Son. For years, I literally soaked up every word he ever spoke about trading options for big profits. I watched him trade. I listened carefully to his reasons. I analyzed his every pick. I did what he did. It was awesome to watch a master trader at work.

As his apprentice, I saw firsthand how my dad raked in profits. And I'll always remember what my dad said to me nearly every day: "Son, options are the best...perhaps the only way to get rich very quickly."

While I was learning trading secrets from my dad, I also earned my college degree, worked on the floor of the Commodity Exchange and founded my own research company, developing my own charting and analytical techniques to build on what my father had taught me.

In 1995, Dad asked me to join him as co-editor of Options Hotline. I was proud that this options genius felt I was ready to join him as his equal. Sadly, my dad passed away in 1999, but his legacy lives on through me and the ongoing success of Options Hotline.

My first solo recommendation was Barrick Gold calls on Oct. 24, 1999. Not my best pick, with a 100% loss, but I made up for it with my next four picks ...

* Home Depot calls, 289%
* AMEX calls, 150%
* Disney calls, 315%
* Cisco calls, 386%.

In fact, my next nine recommendations were all double- and triple-digit winners!

As a subscriber to Options Hotline, you'll get more than 50 years of my dad's options experience...combined with my 30 years of technical analysis...for 80 years of options experience you can depend on to give you the winning picks.

I just don't know where you would find a more authoritative source for profiting from options. But don't take my word for it. Read what Dr. Mike Robinson, a longtime subscriber, said... "I have followed your father's recommendations and now yours. I am very pleased. I am very impressed by your ability to pick specific trades with prophetic wisdom. Somehow you know what's going to happen before the rest of us do!"

when was options invented? 50 years ago???? i remember it was invented in the 70s.....

hissho

 

[wayneL]

when was options invented? 50 years ago???? i remember it was invented in the 70s.....

hissho

The first "standardized" exchange traded option was in 1973.

There could have been negotiated contracts prior to that.

 

[RichKid]

The first "standardized" exchange traded option was in 1973.

There could have been negotiated contracts prior to that.

Just as an aside, and in case someone gets curious, you can look up some interesting historical info on options in this thread.

Feel free to post in that thead if you want to follow up on the historical and socio-economic aspects of options. My guess is Wayne would like this thread to be more about practical questions on trading modern exchange traded options series...

 

[stargazer]

Hi all

Great idea for absolute beginners with options like myself.

I attended a optionetics seminar not long ago and they gave an example of a STRADDLE and made look very easy with very little risk.

Call.....1 contract
Put......1 contract

If price move sideways take a 15% loss at worst.

I have heard they are high risk but on the other hand i have read that they can be a protection from taking a bad loss.

Wayne what i would find helpful would some examples

I have heard of:
Buying shares then RENTING them or writing a covered call: If this is exercised you lose your shares as the price has gone up.

So how does one set up a situation where you win all ways if the stock goes down or up?

Cheers
SG

 

[wayneL]

Hi all

Great idea for absolute beginners with options like myself.

I attended a optionetics seminar not long ago and they gave an example of a STRADDLE and made look very easy with very little risk.

Call.....1 contract
Put......1 contract

If price move sideways take a 15% loss at worst.

I have heard they are high risk but on the other hand i have read that they can be a protection from taking a bad loss.

Wayne what i would find helpful would some examples

I have heard of:
Buying shares then RENTING them or writing a covered call: If this is exercised you lose your shares as the price has gone up.

So how does one set up a situation where you win all ways if the stock goes down or up?

Cheers
SG

Yes they always make it look so easy hey?

There is always risk somewhere unless an arbitrage opportunity surfaces. All options do is repackage that risk and transfer it somewhere else. So the short answer is no. You will have to select where you want your risk to be.

Cheers

 

[stargazer]

Hi Wayne

Thanks for that i understand what you are saying re: arbitrage

So a stop loss in place is just as effective as anything else.

Cheers
SG

 

[wayneL]

Hi Wayne

Thanks for that i understand what you are saying re: arbitrage

So a stop loss in place is just as effective as anything else.

Cheers
SG

Well that depends. Sure, decide a maximum loss where you will pull the pin (and stick to it ). But it depends on what strategy you are using, philosophy, use of leverage, and money management as well.

In many instances I don't use a stop at all... the risk management is built into the strategy.

But thats a topic for a different thread

Cheers

 

[Magdoran]

Hi all

Great idea for absolute beginners with options like myself.

I attended a optionetics seminar not long ago and they gave an example of a STRADDLE and made look very easy with very little risk.

Call.....1 contract
Put......1 contract

If price move sideways take a 15% loss at worst.

I have heard they are high risk but on the other hand i have read that they can be a protection from taking a bad loss.

Wayne what i would find helpful would some examples

I have heard of:
Buying shares then RENTING them or writing a covered call: If this is exercised you lose your shares as the price has gone up.

So how does one set up a situation where you win all ways if the stock goes down or up?

Cheers
SG

Hello stargazer,


A couple of quick observations.

The Optionetics model for straddles (and strangles) I believe follows specific market situations. Their focus at one point was on the US market, and the concept was that you aim to locate stocks with a potential to move strongly up or down.

Key concepts I understand were to locate prospects which fitted this criteria, with one approach suggested was to open a trade early before earnings announcements, and to identify stocks with low volatility. Their criteria also is to exit the position before either leg reaches 30 days till expiry when around 80% of the theta decay occurs (in theory) in the life of an option.

The idea is that interest in the stock increases on or near earnings pushing volatility up which benefits straddles, and that the stock may move strongly in one direction.

Straddles (and strangles) both require a significant move in any direction to make returns, and they are very susceptible to theta decay since you are long both legs. Also, the area of a break even can be very wide if the increments between strikes is wide.

I know of a range of people who have tried this kind of strategy, and the majority could not make it work well. The problem being that theta decay was a problem, and correctly forecasting IV was a challenge, let alone getting the stock movement right. Even when big moves happened, and actually beat the break even line, the cost of entry in commissions and the loss in value of the other leg significantly offset the gains in the winning leg.

Say more than half your trades failed out of a sample and made losses, you would need a couple of great outliers in a group to break even or make a profit overall from an expectancy stand point. Still, there are some who claim this works well, and have specialised in it. It is up to you to determine if you have a gift for getting this kind of trade right.

An alternative approach to this is the ratio back spread. But in this case you need a good volatility skew for these to work well – low volatility in the bought leg, and high volatility in the sold leg. Have a look at these and compare the two. Just remember that these are actually quite involved approaches, and you really need to spend a long time to become proficient in options full stop, let alone with master these strategies.

Straddles and strangles are essentially the opposite of spreads like the butterfly and condor which aim to make money when the underlying trades within a range within a time frame. Just think about this when you are comparing strategies, and where each approach has application to the market conditions you are expecting.

If you’re new to this, I’d suggest spending at least a year either paper trading or trading very small positions to get the hang of it. This is a very challenging area, and you need to keep this in mind despite the enthusiasm some people have for options. They are great… once you know what you are doing. So, just be careful, and accept that this will take some time to learn, maybe even 3 years or more if you’re totally new to this, if your aim is to make consistent profits using options.


Regards



Magdoran

 

[stargazer]

Hi

Thanks for your replies and greatly appreciate your responses.

Yes Magdoran that is correct what you said in relation to Optionetics.

Don't know whether they would use you as their presenter..lol

Well they made it sound so easy about 20 were lined up to purchase the program at around $4000 a pop.

I deduced from reading various material options is a specialised field and your response has reaffirmed this.

Wayne
with my limited knowledge at this stage, if one doesn't use a stop loss which i don't at this stage but am considering it but i have heard of stocks being sold off and then the price shoots up.

Mid caps seem to be manipulated at times and stop losses can trigger selling off etc

So how does one incorprate risk management into a strategy if a stop loss is not used.

Cheers
SG


cheers
SG

 

[toc_bat]

hi everyone

I have a few very basic questions:

Just for example, the company JMS has options JMSO. If I look at market depth using Etrade at JMSO all I see is just the depth. Where do I find out:

a. the date at which these options expire.
b. the exercise price.
c. are these company options? or ETOs?

If I go to the asx company research site for JSM it simply states that no ETOs are available for JSM, yet Etrade lists JSMOs for sale. Why would not the asx site mention these?

Just to confirm, are company options just contracts put out by the company, so that if a trader wishes to exercise them they send thier money to the company which then sells them to the trader direct. ETO options, are they options which can be created by traders themselves, and at exercise time the trader must sell buy the shares in question to the holder of an option.

bye all.

 

[Mofra]

Toc,

Looks like JMSO are company issued options, the exercise price & expiry date would be set by the company at issue & they trade on the ASX.

The options we are discussing here are Exchange Traded Options, which are traded seperately and are a different kettle of fish altogether.

Cheers

 

[toc_bat]

Toc,

Looks like JMSO are company issued options, the exercise price & expiry date would be set by the company at issue & they trade on the ASX.

The options we are discussing here are Exchange Traded Options, which are traded seperately and are a different kettle of fish altogether.

Cheers

Thanks Mofra,

Since etrade and ASX websites do not have JMSO expiry and excercise price info is it a case reading Company anns or websites? Is this situation common?

thanks, bye

 

[Mofra]

Howdy toc,

Companies will have released an announcement with all the relevent info re: the options series, terms of expiry etc.
Company website should also have a list of shares & options on issue, if all else fails most companies have an investor relations contact point which will help you with any questions - they will also provide clarification on fundamental issues relating to the company as well (of course, they wont provide you with anything that has yet to be released to the market - mores the pity : ).

Cheers & good luck

 

[Lismore]

Hi WayneL (or anyone else)

I am just starting papertrading of options on the ASX after 12 months of on and off research.

At the moment i have a main list of options companies - These have high open interest and low volatility (say < 25%)

AMP, ANZ, BIL, CBA, IAG, NAB, NWS, PBL, QAN, QBE, SGB, SUN, TLS, TOL, WBC, WDC, WES, WOW, WPL.

My secondary list is options companies with high open interest and high volatility (> 25%).

AMC AWC BHP BSL LHG NCM OXR RIO STO ZFX.

My main question is on price and delta

If a $5.00 share moves up 5% it is worth $5.25.
If a $25.00 share moves up 5% it is worth $26.25

Assuming all else was equal and delta was 100 the 5% move on both options would be worth a lot more on the $25.00 stock.

I understand that there is leverage (say QAN ATM CALL $0.20, BHP ATM CALL $0.40) but this doesn't seem to compensate.

Am i best to concentrate more on $20+ shares rather that less than $10 shares???

Hope this isn't to silly a question

ps i have read a lot about the problems with volitility..... who takes seriously the implied volitility when trading short term options (say 1-7 days)?

Cheers

 

[wayneL]

Lismore,

I will get to this later unless someone else does

 

[ducati916]

Lismore

This is actually quite similar to the problem that I have encountered myself since starting looking at some of the more esoteric option strategies.
The problem is seemingly with gamma

Implied volatility is a guess-timate based on the current volatility, with an eye looking back at aggregate volatilities [or volatility means, looking for a reversion]

Gamma measures the change in the delta, based on the movement in the stock [delta 1.0, & zero gamma]

The higher your gamma value, the higher or more responsive your delta.
Therefore, with a gamma of 30, your delta in theory should alter by 30 to a change in stock price X

It is all theoretical as, it will alter as time [theta] and volatility [vega] adjust in real time moving into the future. Of the two, vega is the most important and critical, as all the other greeks will key their values off of vega.

Thus the strategies implemented should revolve around vega and estimates, calculations, analysis, best guess, of this variable first and foremost.

If using Options, you are better off going for the higher priced stocks, as a low priced common stock has the hallmarks & advantages of an Option, with none of the drawbacks [theta decay, delta, gamma etc].

jog on
d998

 

[Magdoran]

Hi WayneL (or anyone else)

I am just starting papertrading of options on the ASX after 12 months of on and off research.

At the moment i have a main list of options companies - These have high open interest and low volatility (say < 25%)

AMP, ANZ, BIL, CBA, IAG, NAB, NWS, PBL, QAN, QBE, SGB, SUN, TLS, TOL, WBC, WDC, WES, WOW, WPL.

My secondary list is options companies with high open interest and high volatility (> 25%).

AMC AWC BHP BSL LHG NCM OXR RIO STO ZFX.

My main question is on price and delta

If a $5.00 share moves up 5% it is worth $5.25.
If a $25.00 share moves up 5% it is worth $26.25

Assuming all else was equal and delta was 100 the 5% move on both options would be worth a lot more on the $25.00 stock.

I understand that there is leverage (say QAN ATM CALL $0.20, BHP ATM CALL $0.40) but this doesn't seem to compensate.

Am i best to concentrate more on $20+ shares rather that less than $10 shares???

Hope this isn't to silly a question

ps i have read a lot about the problems with volitility..... who takes seriously the implied volitility when trading short term options (say 1-7 days)?

Cheers

Hello Lismore,


Your question appears deceptively simple, but underpinning answers to this question is a labyrinth of complexity (kind of like the iceberg below the water).

By fixing the delta at 100 in your question, you are effectively circumventing a cornerstone of how options are valued (and for that matter traded), and to answer your question without addressing this key element would really not be that helpful in reality, and give you a highly theoretical answer with very limited practical use. Most traders do not buy deep in the money options with a 100 delta, most buy either ATM, OTM, or slightly ITM.

Ok, having said that, I’ll attempt to answer your question, but in a way that is probably relevant to help you to consider important aspects in real trading scenarios.

In theory, in a situation with all things being equal, there should be very little difference in performance in percentage risk to reward terms between equivalent options for a high priced stock and a lower priced stock – the main differences being that you’d have to buy a different numbers of contracts (hence some difference in OCH fees), and the differential in increments.

By increments I’m refereeing to the half cent step in option prices, hence the fineness of gradation is slightly better in theory for the higher priced stock, since the option price may be much higher meaning that there are more steps per percentage available for finer price steps. For example, a half step for a 20 cent option is one 40th of the current value, while a half cent for a $2 option is one 400th. This may be important in a risk to reward sense to outcomes if precision is required.

There may also be an added cost if you have to buy many contracts, especially if this increases your brokerage fee. At a simple level, just buy more contracts for lower priced stocks. But the more important issues I would argue is liquidity, how good your T/A is, and matching the strategy to the situation – volatility, which strike or strikes to buy/sell, and how big a move in what time frame you are expecting.

Valuing options, and attempting to forecast probable derivative values into the future is an art. It is an art because there are layers of market forces that determine the market value of an option at any given time (supply and demand, market maker activities, trader strategies), and despite the best attempts to develop authoritative option pricing models such as Black and Scholes, and Binomial, these (I would argue) are really a form of sophisticated guestimates when attempting to forecast option prices.

Options are also very versatile. Because you can combine different options into a strategy, and also morph these strategies as the underlying moves, this opens up a range of issues you may not have considered.

Hence evaluating options is complex. There are two broad levels of knowledge to master. One is understanding the Greeks and how options are priced. The second is in using this basic knowledge to determine strategies.

From your comments you seem to be considering using straight options for directional plays (I do this a lot hence comfortable dealing in this area). You may want to consider other approaches later such as non directional strategies, volatility plays, or arbitrage as well as the plethora of directional strategies, or even combinations of these approaches. At least be aware of the fluid nature of option values, and the whole resultant game due to their multifaceted nature both in theory, and in practice.

Where it gets messy is when you add in the concept of delta and volatility (not to mention gamma, theta decay, vega, etc). By buying an out of the money option, the delta is maybe 30 but as it moves into the money, the delta tends to rise, hence the profit levels can accelerate for long option positions. The characteristics of out of the money, at the money, and in the money options are quite different in a straight directional play context based on direction, magnitude, and time.

The challenge is to select an option which presents both good risk to reward parameters that you determine, and also a sufficient probability of success which you estimate. This is much harder than it sounds.

Going back to your question on percentage move in two differently priced stocks, volatility can greatly affect the outcome both on entry and exit. A lot depends on the strike selected (both price and expiry). Hence it is difficult to find equivalent options to compare, partly because the strikes available to trade may vary from stock to stock. Gradation of strikes and price increments in options can lead to quite divergent outcomes, let alone option liquidity, market maker spreads, various market actors, all having an impact on the Greeks, notably volatility.

I trade both high priced stocks and lower priced stocks. Oddly enough I tend to prefer the smaller price levels since the outlays for contracts is less, so I can break my trades into partial positions more easily both scaling into trades, and exiting partials, or re-entering partial positions on counter trends. But this is a personal preference. The percentage returns are really determined by the magnitude of the move in a single series option, and the range of inputs such as the individuals ability to enter and exit the position taking into account the Greeks and the market.

Regarding short term positions 1-7 days, volatility is highly important in my opinion to trade successfully in this time frame. It is easy to pay up for example on a particular day entering long on a reversal, only to see the underlying trade in your direction but the option value fall as volatility crush drags the option value below what you paid for it – even when the stock is moving in your direction. Theta decay can also be a trap, as can delta if you buy too deep in the money or too far out of the money, or the high IV is at the money…

I would suggest that from your questions that you have quite a deal of ground to cover both in theory and practice, maybe try Guy Bower’s book on options as a starter, and then look for Natenberg, McMillan and Cottle. You may also find going through all the option related threads and the different discussions may tease out some of the concepts in this post in more detail. It’s probably worth spending the time reading these.


Good luck, and I hope this makes some sense to you.

Regards


Magdoran

 

[ducati916]

Mag's baby!

Regarding short term positions 1-7 days, volatility is highly important in my opinion to trade successfully in this time frame. It is easy to pay up for example on a particular day entering long on a reversal, only to see the underlying trade in your direction but the option value fall as volatility crush drags the option value below what you paid for it – even when the stock is moving in your direction.

This is the interesting area for myself.
Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.

Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?

Interested in your response.
jog on
d998